Against the Grain

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What is the Millennial Trade?

I don’t understand millennials. But I realize that needs to change if I’m going to continue investing in the stock market. As the largest demographic since the baby boomers enters adulthood, their behaviors and preferences will obviously play a dominant factor in determining which companies succeed and which companies bomb out over the next several years.

We’ve all heard the sweeping generalizations about the 80 million or so millennials out there: urban dwellers, renters, entitled career climbers, more health conscious, more burdened with debt, more attention seeking, more comfortable challenging authority, more liberal, more diverse, negative patience, and more talented than any generation before it.

This post could go in a lot of different directions, but I want to focus on one trend that is being driven in part by millennials, which is the significant increase in both new supply for apartments and rental rates, particularly in urban infill locations and cities with strong job growth trends like Denver, where I live. To give you an idea of how hot the rental market has become in Denver, average apartment rents have increased 9.5% in the last 12 months alone despite delivery of almost 10,000 new units, which is more than what was delivered in the last 10 years combined. Up to this point developers can’t build new projects fast enough to meet the demand of young professionals who (i) want to live in an urban environment, (ii) can’t afford a down payment on a house, and (iii) are willing to pay whatever it takes to have the newest space in the heart of the action. This trend is certainly not unique to Denver- it comes as no surprise that multifamily REIT’s are up over 30% in the past year amidst the perfect storm of rising rents and record low interest rates.

I get that the urban density trend is not going away any time soon and that millennials think about housing differently than prior generations, but I recently came across a few data points relative to Denver that have led me to believe that the rental market is officially jumping the shark.

According to a recent study by Zillow, typical renters in Denver are spending 31.8% of their income on rent compared to 21.6% historically. Additionally, average rents in Denver have risen to $1,712 per month, compared with a median mortgage payment of $1,375.

When I see the data above, all I can think to myself is (i) there is no way that spending over 31% of your income on rent is sustainable or desirable under any circumstance, and (ii) I suspect this is driven more by the circumstances of millennials (single with debt) than their true long-term preferences. We won’t know how deeply entrenched millennials’ views on urban living are until they start having families and are faced with more difficult consequences and trade-offs of the urban vs. suburban environment.

I’m fairly confident I know the answer to both questions above, but the tricky part is the timing. (It’s like shorting treasuries- eventually everyone knows that rates are going up, but anyone who has shorted them so far has likely been crushed due to poor timing.)

All this rambling leads me to the conclusion that I’m interested playing the overheated rental market by looking at the home builder stocks, particularly KB Homes (KBH), Pulte (PHM), or maybe Taylor Morrison (TMHC). Despite rising home prices and low interest rates, the home builder stocks haven’t seen the same kind of appreciation that apartment players have experienced. In fact, many home builder stocks are actually down over the past 12 months (KBH, for example, is down 1% over the last 12 months and Taylor Morrison is down 14%).

I find this particularly strange because in a place like Denver, the existing home sale market is also on fire- there is virtually no inventory available and multiple buyers are showing up the day most homes are listed. My personal observation has been that most people with children and funds available for a down payment are seeking a very similar style of living that was preferred by prior generations. There may be little nuances about proximity to public transportation or willingness to forego big lawns, but I think that the home builders are poised very well to benefit from millennials in the manner that apartment developers have seen to date- especially since they seem to be willing to pay up for quality new construction. In fact, I would think that the apartment REIT performance and Home Builder stock performance should eventually converge given how close the cost of renting has come to the cost of home ownership over the past year. That could mean a huge drop in multifamily REIT values to meet up with home builder stocks, a “meeting in the middle” of both asset classes, or a big rise in home builder values to catch up with the multifamily players. 2 out of the 3 scenarios result in home builder stock appreciation.

From a valuation and financial stability standpoint I feel OK about buying some home builder stocks today: PHM, KBH, and TMHC all have attractive forward P/E’s between 9 and 12, ample land inventory, strong revenue growth over the past year and great reputations for being quality home builders. When looking at debt levels and Price/ Book, however, one group stands out from the pack: Pulte Homes (PHM)- they have shockingly less debt than their competitors (0.4 debt/ equity ratio vs. upwards of 3.5 for TMHC and KBH), ample cash, and an attractive Price/ Book ratio of 1.5, which his below the industry average of 1.8. As a result is doesn’t come as a surprise that PHM is the one stock in the group that has seen some decent price appreciation in the last year at 11%.

I have surveyed several smart people about their views on the home builder market, including two seasoned professionals in the industry. While they generally agreed with the long-term demographic factors favoring home builders, there were some valid short-term concerns raised such as timing on millennial taste-shifting, overhang from the huge run homebuilders have already experienced in the past 5 years, rising construction costs, and rising rates.

Before investing I need to do some more research and dig deeper into their filings to confirm that the business is poised for growth and well positioned against its peers, but I think the time is ripe to add a home builder to the ATG portfolio. This is just the first of many “Millennial Trades” we’ll ponder in building a portfolio that can withstand, and prosper from the onslaught of these strange beings.